Now, worry about the upturn

Small firms risk financial starvation just as the economy recovers

JUST when you thought an upswing was around the corner it seems that smaller firms have yet to face the worst. Nick Hood, executive chairman of Begbies Global Network, an insolvency firm, predicts an increase in insolvencies in the second quarter of next year and continuing into 2011. Insolvencies, like unemployment, are a lagging economic indicator. Both rose markedly after downturns in 1974, 1980 and 1990.

But other factors are exacerbating matters now. One is the lack of competition among lenders. Foreign institutions, which used to account for about 40% of company lending, have mostly gone home; domestic players have merged; and the market is dominated by four big banks. When they do find a willing lender, small firms are paying through the nose. The difference between the average interest rate on their loans and the central bank's base rate shrank from April to July, but increased again in August to 3.5 percentage points, according to the Bank of England.

There have been some, largely unsung, successes. The government's enterprise-finance guarantee scheme, which ensures repayment of 75% of a bank loan to eligible small companies, has so far covered £648m-worth of loans to 6,200 businesses. The target is £1.3 billion. More impressively, perhaps, some 215,000 businesses have grabbed hold of a government lifeline allowing tax deferral, postponing liabilities totalling around £3.8 billion.

That is applauded by the Confederation of British Industry, among others. But Mr Hood is concerned that, although tax deferrals are a boon for vibrant firms in temporary need of working capital, they may allow ailing companies to continue trading to the detriment of their suppliers and creditors. Her Majesty's Revenue & Customs, a preferred creditor, is not worried about getting paid. But the taxman is often the creditor who tips a firm into bankruptcy, says Mr Hood.

For small British firms facing a squeeze there are desperately few alternatives to bank finance. Adam Posen, a member of the Bank of England's Monetary Policy Committee, lamented that fact in a speech in October. He drew parallels with Japan in the 1990s, when the central bank was unable to bypass the banks and get financing through to the wider economy. The same constraint has been apparent in the Bank of England's £200 billion programme of quantitative easing: the bank has found only a few corporate assets to buy with its enormous war-chest, and has spent most of the money on government bonds. That reveals a “long-term structural problem” in Britain's financial markets that could be of “potential harm” as the economy begins to recover, Mr Posen said.

Lloyds Banking Group, one of the big four lenders, is worried that many businesses are “sleepwalking” towards economic recovery. A survey in September of 500 senior managers of small companies showed that one-third of them had not taken any steps to prepare their firm for an upturn. When companies start growing again they suddenly need more working capital: they risk falling into the trap of overtrading, the bank warned.

The Forum of Private Business, which represents over 25,000 small firms, is lobbying for cuts in tax and social security rates to help small companies at this critical point in the cycle. It will be hoping for good news in the pre-budget report on December 9th. But so, alas, is everyone else.